Principles of Economics: Unit 1 - Foundations

Objectives of Unit 1

• Understand what economics is.
• Learn how economists think.
• Recognize the value of an economist’s perspective.
• Analyze how people make decisions.
• Explore how economies function.

What is Economics?

• Economics is a social science aimed at satisfying needs and wants through allocating scarce resources with alternative uses.
• Focuses on scarcity and choice.
• Provides a framework for analyzing economic and some non-economic problems.

Economist's Perspective

• Five fundamental ideas:
  1. People respond to incentives.
  2. Resources are scarce.
  3. Real values matter.
  4. Prices reflect scarcity.
  5. Returns eventually diminish.

1st Foundation: People Respond to Incentives

• Incentives affect behavior; improvements in benefits/costs lead to increased participation.
• Incentives can be financial or non-financial, such as social approval or personal morals.
• Economic rationality refers to predictable group behavior in response to changing incentives.
• Understanding incentives is crucial to grasping economic decision-making.

2nd Foundation: Resources are Scarce

• Unlimited desires vs. limited resources necessitate choices and trade-offs.
• Opportunity cost: The value of the best alternative forgone when making a choice.
• Nothing is truly free; every choice incurs an opportunity cost.

3rd Foundation: Real Values Matter

• Decisions assess benefits/costs in real terms, which consider purchasing power.
• Nominal values, derived from currency, can be misleading due to inflation.
• Real values guide economic behavior more reliably than nominal values.

4th Foundation: Prices Reflect Scarcity

• Prices adjust according to changes in supply and demand; increased scarcity leads to higher prices.
• Price changes serve as a market signal to guide economic adjustments.
• Sometimes prices lag behind changes in market conditions.

5th Foundation: Returns Eventually Diminish

• Each additional unit of input yields decreasing marginal returns when other factors are unchanged.
• Diminishing returns affects decision-making in both consumption and production.
• Economic choices depend on the marginal benefits of efforts.

Pulling it All Together: How an Economy Works

• Interconnected markets respond to supply, demand, and price changes.
• The mechanism of price signals encourages responsive behavior in consumers and producers, illustrating the concept of the "Invisible Hand" of the marketplace, as noted by Adam Smith.